Rematch between Keynes and Hayek

By Robert Skidelsky

The Austrian economist Friedrich von Hayek, who died in 1992 at the age of 93, once remarked that to have the last word requires only outliving your opponents. His great good fortune was to outlive John Maynard Keynes by almost 50 years and therefore to claim a posthumous victory over a rival who had savaged him intellectually while he was alive.

Hayek’s apotheosis came in the 1980s, when then-British prime minister Margaret Thatcher took to quoting from The Road to Serfdom (1944), his classic attack on central planning. However, in economics there are never any final verdicts. While Hayek’s defense of the market system against the gross inefficiency of central planning won increasing assent, Keynes’ view that market systems require continuous stabilization lingered on in finance ministries and central banks.

Both traditions, though, were eclipsed by the Chicago school of “rational expectations,” which has dominated mainstream economics for the past 25 years. With economic agents supposedly possessing perfect information about all possible contingencies, systemic crises could never happen except as a result of accidents and surprises beyond the reach of economic theory.

The global economic collapse of 2007-2008 discredited “rational expectations” economics (though its high priests have yet to recognize this) and brought both Keynes and Hayek back into posthumous contention. The issues have not changed much since their argument began in the Great Depression of the 1930s. What causes market economies to collapse? What is the right response to a collapse? What is the best way to prevent future collapses?

For Hayek in the early 1930s, and for Hayek’s followers today, the “crisis” results from over-investment relative to the supply of savings, made possible by excessive credit expansion. Banks lend at lower interest rates than genuine savers would have demanded, making all kinds of investment projects temporarily profitable.

However, because these investments do not reflect the real preferences of agents for future over current consumption, the savings necessary to complete them are not available. They can be kept going for a time by monetary injections from the central bank, but market participants eventually realize that there are not enough savings to complete all the investment projects. At that point, boom turns to bust.

Every artificial boom therefore carries the seeds of its own destruction. Recovery consists of liquidating the misallocations, reducing consumption and increasing saving.

Keynes (and Keynesians today) would think of the crisis as resulting from the opposite cause: under-investment relative to the supply of saving — that is, too little consumption or aggregate demand to maintain a full-employment level of investment — which is bound to lead to a collapse of profit expectations.

Again, the situation can be kept going for a time by resorting to consumer-debt finance, but eventually consumers become over-leveraged and curtail their purchases. Indeed, the Keynesian and Hayekian explanations of the origins of the crisis are actually not very different, with over-indebtedness playing the key role in both accounts. However, the conclusions to which the two theories point are very different.

Whereas for Hayek, recovery requires the liquidation of excessive investments and an increase in consumer saving, for Keynes it consists of reducing the propensity to save and increasing consumption in order to sustain companies’ profit expectations. Hayek demands more austerity, Keynes more spending.